Recently the Securities and Exchange Commission (SEC) granted a temporary exemption from Rule 17g-5(a)(3) for credit ratings provided to most ABS, MBS and other structured finance securities of non-U.S. issuers. This reprieve expires on Dec. 2 and extends from June 2, which is the rule's effective date for domestic firms.
The SEC's stated purpose for this move was to avoid market disruption by giving foreign structured finance participants time to take the necessary steps to comply with the rule.
Despite the reprieve, however, sources said that there are still major issues that foreign ABS players are left to grapple with. This is especially true because the SEC did not give any sort of opinion as to the consistency of its legislative authority to regulate deals occurring outside the U.S.
"While the postponement requested by a number of non-U.S. regulators is positive, the exmption for European ABS is only temporary, " Deutsche Bank analysts wrote. They added that unless a third way can be found, this exemption for instruments sold outside the U.S., "will lead to to the highly unusual situation where the SEC will effectively be setting regulations in European jurisdictions." This further hinders issuers from this region from coming back to the ABS markets, analysts said.
Rule 17g-5 was adopted as part of the Credit Rating Agency Reform Act of 2006. It compels SEC-registered credit rating agencies or nationally recognized statistical rating organizations (NRSROs) to comply with certain limitations and procedures. These requirements were implemented to mitigate perceived conflicts of interest.
This particular ruling requires NRSROs paid to rate a structured finance product to get from the deal's arranger - in this case, the issuer, sponsor or underwriter-an agreement to post to a password-protected Web site all information provided in connection with the product's rating or any subsequent surveillance.
The data should be made accessible to the other NRSROs that were not hired to rate the security. The term "structured finance products" under this rule covers most ABS, MBS, CMBS, and ABCP, as well as other securities backed by pools of assets, whether or not these constitute ABS subject to the SEC's Regulation AB.
The SEC implied its consideration of a permanent exemption by requesting comment on the following: possible conflict with local regulation; whether a rating firm that is considering applying for NRSRO status actually intends to utilize the available information from arrangers as contemplated by 17g-5; factors used in determining whether the types of structured finance and similar products sold outside the country should fall under the rule; and the costs involved and the steps taken by NRSROs and arrangers to comply with the rule.
The SEC's request recognizes the lack of an investor-pay market for unsolicited third-party public ratings as well as shows its receptiveness to discuss the financial products covered that are mostly issued outside the U.S., including covered bonds.
Complying with the Rules
The major NRSROs (specifically Standard & Poor's, Moody's Investors Service and Fitch Ratings), according to an Allen & Overy client alert, have voluntary registered with the SEC most if not all of the legal entities that they use to rate securities across the globe. Because of this, the SEC's NRSRO regulations such as Rule 17g-5 apply to the structured finance that they rate worldwide. However, some rating agencies have resisted registering with the SEC their affiliates that deal only with transactions solely outside the U.S.
Aside from this, resistance has also come from non-U.S. regulators that have their own regulatory regime as well as smaller issuers who have either never heard of 17g-5 or are unprepared for the additional cost that this rule would entail.
As Allen Overy's client alert said: "The rule's worldwide scope came as a surprise to many foreign originators and regulators and raises concerns due to, inter alia, the potential conflict of the rule with existing non-U.S. laws and regulations."
Exacerbating the problem for ABS issuers is that the burden of interpreting the rule has been shifted mostly to them, as the onus for compliance with its requirements would fall on these companies.
There are several issues that need clarification. One is complying with and reconciling views on the types of information that need to be provided, including what data to post on the Web site in terms of the oral conversations that occur between the issuers and the rating agencies. There are several questions that need to be answered: Can a material posting be a recording of a conversation or an abstract or a summary of the discussion? How can rating agency tours of originators' facilities be captured?
"There's uncertainty on how you deal with the oral information, how much of it is material," said Jerry Marlatt, senior of counsel at Morrison Foerster. He added that there is talk of issuers hiring services that provide automated transcripts of conversations. "However, editing the transcripts might be difficult in terms of distinguishing what's material and what's not," he said.
Issuers, Marlatt said, have some very difficult issues to deal with. For example, if between the time one begins marketing and the closing of a deal, another rating agency issues an unsolicited rating, what are the disclosure rules for this particular situation? "Should you inform investors of the unsolicited rating, particularly if the unsolicited one is lower?" he said.
Another problem is that, particularly around structured transactions, there is often an exchange between the issuer and the rating agency on the various workings of a security. "This is a process that would be difficult to achieve in writing - it needs a free form discussion," he said. The rating agency might question how an issuer might change a structure and the issuer might respond back with alternative approaches. "This back and forth makes the disclosure process required by 17g-5 a little more difficult," Marlatt said.
In short, the rule, sources said, limits the interactive approach in rating transactions, although it might be good from the investor's perspective to have information that is well documented, it might have a chilling effect on rating agencies' interactions with issuers.
Conversations between the investment banking side and these rating agencies might be limited as well. Sources said that usually before investment banks would structure a deal for a particular issuer, there were conversations about what might work and what might not. However, the rule further formalizes communication between these parties. Every issuer and underwriter has to comply with the procedures so there's going to be internal education on what can and can't be done.
The rule's extra-jurisdictional impact has raised questions on how this would interfere with existing laws in the various foreign jurisdictions. The issue of consumer protection laws, for instance, where publishing information on an obligor might not be covered by a particular country's laws.
There are still a lot of gray areas in implementing Rule 17g-5. According to Allen & Overy's alert, it's unclear how the requirement should apply in the context of ratings provided in respect to previously established and rated ABCP programs, which types of data are required to be made available through the Web site and how the compliance date of June 2 should be interpreted. However, there is somewhat of a market consensus that this rule would apply to engagements entered into from the compliance date.
Despite the onus of compliance being on ABS issuers, Rule 17g-5 technically imposes requirements on NRSROs rather than arrangers directly, Allen & Overy's client alert said.
As of press time, only Fitch Ratings has commented on the SEC's reprieve for foreign issuers.
The rating agency said that while the temporary exemption should cover many non-U.S. deals, it thinks that it will not cover any offering where U.S. investors are targeted. It cited the SEC, which gave as an example of a deal outside the U.S. as any offering that complies with the applicable Safe Harbor available under Rules 903 and 904 of Regulation S. "These Safe Harbor rules apply only to an 'offshore transaction,' which generally is a transaction where offers cannot be made to persons in the United States and all buyers of the securities must be outside the United States at the time they purchase the security," Fitch said.
The rating agency said that the following asset classes are not considered by Fitch to fall under Rule 17g-5: covered bonds or similar dual recourse securities, derivative product companies, enhanced equipment trust certificates, whole business/corporate securitizations, project finance, tender option bonds, and utility and other forms of mortgage bonds.
Meanwhile, the rating agency believes the rule applies to the following securities regardless of tranching structure : all ABS, RMBS, CDOs, CMBS, insurance securizations, SIVs and ABCP programs.
